In practice however the benefits of income diversification are less clear

In practice however the benefits of income

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In practice, however, the benefits of income diversification are less clear. Several authors argue that non-interest income is usually more volatile than interest income and allows banks to be more leveraged, because regulators often require banks to hold less capital against non-interest income activities [DeYoung 9 These banks are mainly located in E.U. countries that experienced real-estate bubble in the pre-crisis period, such as the Spanish cajas. 10 In Spain, for example, Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA), the country’s two largest banks, were much less affected by the crisis than the considerably smaller cajas. Ayadi et al. (2011), for example, show that among Europe’s largest banks those identified as retail banks performed better and were more stable during the financial crisis. 11 For papers on geographic diversification in banking see García–Herrero and Vazques (2013) and Böninghausen and Köhler (2012). and Roland (2001), Stiroh (2004a, b)]. All of this might offset the benefits of diversifying into non-interest income and make banks more risky, not less. Overall, therefore, it is an empirical question whether expanding into non-interest income activities makes banks more stable. For this reason, many empirical studies have been published over the past few decades. Most of these studies find only little evidence of gains from diversifying into non-interest income. 12 Motivated by the financial crisis, more recent studies examine not only the impact of income diversification, but also how the diversification of funding sources affects banks’ risk and return. It is not clear whether diversification into wholesale funding makes a bank more or less risky, either. Experience from the financial crisis suggests that banks that are dependent on deposits for funding are stable, because customer deposits are less likely to be withdrawn prematurely than wholesale funds. The price of wholesale funds also adjusts more quickly to reflect a bank’s riskiness. Customer deposits, in contrast, are more stable and slower to be repriced, not least because they are protected by deposit insurance [Shleifer and Vishny (2010)] and held for liquidity purposes [Song and Thakor (2007)]. However, according to theory, wholesale funding may also reduce risk-taking if sophisticated wholesale financiers are better at monitoring than small depositors [Calomiris and Kahn (1991)]. Similar to the results for income diversification, the academic literature provides mixed evidence on the effects of funding diversification on bank risk and return as well. Altunbas et al. (2011), for example, find that banks that were more dependent on non-deposit funding were more likely to fail during the financial crisis, while a better diversification of income sources was found to increase their stability. Demirgüc–Kunt and Huizinga (2010) find some risk diversification benefits at very low levels of non-interest income and non-deposit funding as well.
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